Surviving ’Taxmageddon’ Without Maiming Economy

April 25 (Bloomberg) -- The nation is hurtling toward what
has been called “taxmageddon,” the enormous tax increases and
spending cuts scheduled for the beginning of 2013. At around the
same time, we will also be spending some more quality time with
our old friend: the debt limit.

No one can yet see a plausible way through the coming
storm. But even though they are not particularly inspiring,
paths away from catastrophe do exist.

First, some brief background. At the end of this year, all
the Bush tax cuts expire -- amounting to about $250 billion a
year. The payroll-tax holiday, at more than $100 billion a year,
ends too, as do expanded unemployment-insurance benefits. And we
face other spending cuts of about $100 billion, from the
sequester set up by the 2011 debt-limit deal.

All told, this fiscal tightening adds up to about $500
billion -- or more than 3 percent of gross domestic product. The
economy will be in no shape to handle that much of a squeeze. If
we do nothing to reduce or stop it, the economy could be thrown
back into a recession.

As if that were not challenging enough, we are expected to
bump back up against the debt limit, which currently stands at
$16.4 trillion. Projections suggest we will approach the limit
in the fourth quarter of 2012. Then, the Treasury secretary will
take temporary measures to allow continued issuance of debt. The
Bipartisan Policy Center estimates those actions will get us to
February 2013 -- at which point we will hit the debt-limit wall.
If the economy is weaker than expected, it will widen the
deficit faster, and we’ll hit the wall sooner.

Alternate Scenarios

In thinking through the options for getting past this mess,
let’s assume that, after this fall’s elections, the House of
Representatives remains Republican. A presidential victory by
Mitt Romney would then probably mean that nothing would get done
during Congress’s lame-duck session at the end of 2012. After
all, why shouldn’t House Republicans just wait to deal with the
incoming Republican president?

After Romney took office, his administration would
presumably negotiate a temporary deal to retroactively reinstate
the tax cuts to the beginning of 2013, lift the spending
reductions and raise the debt limit for a few months.
Republicans would then try to pass a budget resolution and use
the reconciliation process -- which allows measures to pass with
only 51 votes in the Senate, rather than 60 -- to enact
substantial and flawed structural reforms to Medicare and
Medicaid (like block-granting Medicaid), and large reductions in
programs such as food stamps and Pell Grants.

On the other hand, if Barack Obama is re-elected, an
attempt may be made to reach a deal before Jan. 1. The key
problem with this scenario is that the Obama administration and
House Republicans have irreconcilable differences over the Bush
tax cuts: The administration insists that the cuts for people
with incomes above $250,000 not be extended again, and the House
Republicans insist that they must be. With such a sharp line
drawn in the sand, it’s not clear how a deal could magically
happen before the end of the year.

One possibility would be for the two sides to adopt, during
the lame-duck session, a “framework” agreement that would set
deficit-reduction goals but provide few, if any, specifics. The
tax cuts could be extended and the debt limit raised temporarily
as negotiators worked out the details.

Two obstacles to such a framework approach immediately come
to mind. First, buying a little more time would only push the
problems down the road -- until the next deadline approached.
Second, even temporary extensions of the tax cuts would require
a compromise: Would we extend all of them (presumably, the
administration wouldn’t want to) or only those for taxpayers
with incomes below $250,000 (House Republicans wouldn’t like
that)?

Lame-Duck Difficulties

Given such difficulties, it might not be possible to reach
a framework agreement during the lame duck. Then, all the tax
cuts would expire. A dramatic scenario, but this, unfortunately,
may be the most likely.

In January 2013, the economy would be hit with a major
fiscal contraction, market anxiety would rise, and both sides
would blame each other for Washington’s dysfunction. But there
would be a silver lining: The debate could then move away from
the question of which tax cuts to extend.

If we get to this point, the administration could step
forward with an entirely different concept for decreasing taxes.
It could propose, for example, large increases in the payroll-tax holiday and in the standard income-tax deduction. This would
reduce taxes for everyone, but do it in a much more progressive
fashion than the Bush tax cuts did. The net result of the new
tax cuts and the expiration of the Bush ones would be higher
taxes for upper-income people, as the administration desires.

The president could then dare the Republicans to vote
against the new universal tax cut. Republicans would have a
harder time withholding support for such an across-the-board tax
cut in early 2013, once the Bush tax cuts are water under the
bridge, than they would have had holding firm on extending all
the Bush tax cuts in late 2012.

Resolving the tax issue in that way wouldn’t be enough to
raise the debt limit and waive the sequestration spending cuts.
To accomplish those things, House Republicans will demand some
changes to entitlement programs. The question is whether they
would push only for the relatively modest reforms discussed last
summer (such as using the so-called superlative consumer price
index to make cost-of-living adjustments in Social Security) or
demand bigger structural changes (such as premium support in
Medicare).

It’s tempting to feel nostalgic for the days when Congress
wasn’t so polarized, and the confluence of a substantial tax-cut
expiration, a huge spending cut and the debt limit would
virtually guarantee a major piece of legislation. Taxmageddon
highlights how much more challenging our system has become.

In navigating through the coming storm, we need to avoid
undue fiscal contraction (and preferably provide additional
support to the economy if the unemployment rate remains
elevated) but also recognize that enacting a debt-limit increase
will require some long-term deficit reduction -- which would be
desirable in any case. The coming debate thus shows, once again,
the benefit of a dual strategy in which we continue to provide
stimulus to the economy in the short run but enact substantial
deficit reduction that takes effect down the road.

(Peter Orszag is vice chairman of global banking at
Citigroup Inc. and a former director of the Office of Management
and Budget in the Obama administration. The opinions expressed
are his own.)

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